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How to Invest in and Trade Commodities – What You Need To Know

Gold. Crude Oil. Natural Gas. Copper. Commodities are present in every facet of our daily lives. We all seem to be sensitive to the price of gas at the pump, what it costs to heat our house, and what we pay at the grocery store. When we turn on CNBC, the ticker not only shows the Dow and the Nasdaq, but oil, gold, silver, and a host of other products that have become almost mainstream. Niche products, such as frozen orange juice (think of the film “Trading Places”) and coffee, have become chat room staples.

The list of commodities the average investor can trade has exploded in the last 10 years. What was once the playing field for farmers, merchants, and end users to hedge their price risk is now an ever-expanding list of products designed to give customers exposure to the price fluctuations of everyday goods used by people and companies around the world. This brings up two very important questions you should ask yourself:

Should I be investing in commodities?

If I so, how do I do it?

Who Uses Commodity Markets?

Commodity pits have been around for over a hundred years. They had their origins in the heartland of the country, in Chicago, when the Chicago Board of Trade and the Chicago Mercantile Exchange were founded. The purpose of these exchanges was to create a futures market, a place where standardized contracts are traded for specific amounts of a commodity or financial product to be delivered on a specific future date. These markets originally enabled farmers to lock in prices for their crops before they were harvested, helping to reduce their risk of price fluctuation. Similarly, end-users could pay for raw goods in advance, thus knowing some of their input costs and stabilizing their pricing structure for consumers.

These and other useful applications for commodity futures still exist in today’s world. Aside from grains and meat, now we have markets for virtually every raw good consumed today: energy (crude oil, natural gas, gasoline, electricity), metals (gold, silver, copper), soft commodities (sugar, cotton, coffee), and even frozen orange juice, cocoa, lumber, and platinum. If you think about all the things in your home that you use and consume on a daily basis, commodities are everywhere in our lives.

Commodity futures used for the purposes for which they were developed help to stabilize prices. For example, airlines can lock in a price for jet fuel now and try to insulate themselves from a potential spike in prices in the following year; clothing manufacturers can reduce the risk of a drought in the South by buying their cotton months before the crop has been planted; and Procter & Gamble can buy corn and rice to make cereal two years from now. By knowing their future input costs, these manufacturers and end-users can accurately predict what it will cost to fly a jet, make a shirt, and produce breakfast cereals.

Role of Speculators

Nowadays, the commodity markets have become the home of a third type of player: the speculator. Speculators don’t produce a raw good, and they don’t actually want those goods at delivery time. They are simply buying and selling these products to make a profit on the constant fluctuations in prices.

Originally, most speculators were on the trading floor. Locals, as they were known, would try to take advantage of short-term price discrepancies and inefficiencies in the commodity markets for personal profit. These savvy traders would provide liquidity when either producers or end-users had no interest in trading at a particular price. They possessed a deep understanding of the products and how to price these instruments quickly and accurately. Overall, they provided a valuable function to the daily activity on the exchange floor.

In today’s world, locals are not much of a factor in the commodity markets. Huge investment banks, hedge funds, and commodity funds trade enormous amounts of these products. Their goal is not to capture the short-term market inefficiencies, but to take large stakes in a variety of products so that a large move in the price of an instrument will benefit them and their customers. Like locals, these huge players do not want the end product, and they often take positions that profit when the price of a commodity goes down, called “shorting.”

Are These Products for Me?

Most financial advisors today would tell you that a small portion of your investment portfolio should be in commodities. Even though futures are designed for producers and end-users, we all are subject to the risks associated with higher costs for food, energy, and construction. This is known as inflation.

Hedging Inflation

Owning commodities can be an important hedge against inflation – even if you have a relatively modest portfolio. The continuing growth in the global economy has created strong demand for a variety of raw materials – from oil, to metals, to lumber. That demand, in turn, puts upward pressure on the prices of those commodities. Since inflation can hurt other investments, such as stocks and bonds, investing in commodities can help to soften the blow when global inflationary pressures hurt equity and bond markets.

Risk Tolerance

The most important factor in deciding to invest in commodities, however, is your own personal risk tolerance. Highly volatile products like crude oil, natural gas, coffee, gold, silver, and cotton move much further in price at a much greater rate than most investment products. Unlike stocks, there are no earnings or dividends to fall back on with commodities. It’s a pure price play: If the price goes up, you make money; if the price goes down, you don’t. If you watch your portfolio every day and constantly trade in and out of positions based on your account value, this is probably not for you. If you can take a long-term view and understand that these fluctuations occur often, then you would be better suited for the volatility associated with these markets.

Count Warren Buffett among famous investors who do not like commodities for the average investor. “The problem with commodities is that you are betting on what someone else would pay for them in six months,” Buffett says. “The commodity itself isn’t going to do anything for you – it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.”

Futures

Traditionally, in order to trade commodities, you needed to trade commodity futures – and you can still do this today. You need to open an account with a futures trading firm, acquire the front-end trading software, and put up a boatload of money (due to the risk involved in futures).

This approach is not for the average investor. Futures trading involves a great deal of risk and requires professional trading skill, and it is for people who literally devote their lives to trading. Understanding of market fundamentals and technical analysis are a must. Having spent the last 20 years of my life trading futures, my advice is simply don’t do it.

Exchange Traded Funds

Virtually every investor today has heard of exchange traded funds, or ETFs. An ETF is an instrument that trades like a stock and tracks the price of another instrument. For example, an ETF for the S&P 500 index moves up and down in price almost identically to the actual index.

Difficulties With Commodity ETFs

Commodity ETFs are much trickier than stock index ETFs. Commodities are based on futures which have a delivery date at some future set time. Since there are many time frames in which to trade a commodity, the ETF tracks a price based on many future prices of that commodity.

For instance, one of the largest commodity ETFs, called USO, tracks the price of crude oil. Let’s say that crude oil for delivery in one month (called the “spot month”) is trading $100 per barrel. Crude for delivery in two months may be trading $103 per barrel, and crude for delivery in three months is trading $106 per barrel. The price you see on CNBC is for the spot month: $100. But USO buys crude for delivery in many months: some in the spot month, but some for delivery in two months, three months, six months, and so on.

If you were to buy USO now and see a price of $100 for crude, and a month from now you see a price of $101.50 on CNBC, you would think you’ve made money. This is incorrect – you lost money, because when you purchased USO, the two-month price was $103, but after two months it is only trading at $101.50. This is a common source of frustration for investors.

Term Structures

This pricing pattern for future months is called the “term structure” of the market. When the price of something is higher in the future than it is now, the term structure is said to be in “contango.” If the price in the future is lower than it is currently, it is in “backwardation.”

Contango and backwardation make trading certain commodity ETFs problematic. This is because the price of a product can literally jump when you stop trading one month and begin trading another month, but the price of the ETF may not move – or it may move in the other direction. In commodities like energies, grains, and soft commodities in which the term structure is driven primarily by supply and demand, this can confuse and frustrate investors.

Commodity ETFs for products like metals (gold, silver, copper) and currencies tend to have a different term structure. Their term structures are determined largely by interest rates. So as you move from trading one month to the next, the prices actually converge on each other, creating a seamless transition. ETFs for these products generally do a much better job of tracking the spot price of the underlying instrument. For this reason, I recommend trading an ETF for gold, silver, copper, and all currencies and bonds, but not for energy, grains, meats, and soft commodities. In short, financial product ETFs are good; pure commodities are not so good.

If you really desire an ETF for things like energy, consider sector ETFs like the Energy Select Sector SPDR (XLE), Oil Services HOLDRs (OIH), and iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ) that hold shares of stock in real operating businesses – not the futures. Even though these ETFs don’t directly hold the crude oil futures, the companies that they invest in profit from higher prices for oil.

Mutual Funds

Another way to gain exposure to commodities is to purchase mutual funds and index funds. Like sector ETFs, these funds don’t directly invest in the commodities, but rather invest money in companies that are closely tied to commodities. The reasoning is that if the commodity does well, then the company will also do well. Most of these types of funds are not sector-specific, but rather seek to gain an exposure to many commodities through the purchase of stocks.

Two effective funds are:

U.S. Global Investors Global Resources Fund (PSPFX). This fund invests in oil exploration stocks, gold mining stocks, and other companies tied to natural resources. The three-year load-adjusted return is 20.06%, and the fund ranks in the top 10 in its class for expense ratio.

Pimco Commodity Real Return Strategy (PCRAX). This fund seeks exposure to a basket of broadly diversified commodities by not just focusing on energy and metals, but by also purchasing shares in companies that profit from higher grain prices, consumer staples companies, and U.S. Treasury notes. It has a three-year load-adjusted return of 15.38%.

Index Funds

Commodity index funds are designed to track the performance of a specific commodity index, such as the Goldman Sachs Commodity Index (GSCI) or the Deutsche Bank Commodity Index. These funds try to mirror the performance of the index in the same way the SPY tracks the performance of the S&P 500.

For the GSCI Index, look at the iShares GSCI Commodity-Indexed Trust Fund (NYSEARCA: GSG). GSG gives you the same exposure to the index, along with the added value of daily liquidity ($1.4 in AUM) and daily redemptions.

For the Deutsche Bank Commodity Index, there is an ETF that tracks it (NYSEARCA: DBC). DBC is the first ETF on the market to track a commodity index fund; in this case, the Deutsche Bank Commodity Index Fund. The DBC is a good ETF if you seek balanced exposure to commodities. Also, with more than $6 billion in assets, this is the most widely tracked commodity index ETF in the market.

Of course, you could always do your own research and pick commodity-related stocks to devise your own fund – just be sure that the companies you look for have real earnings, solid balance sheets, and actually deal directly with the industry you are trying to gain exposure to.

Final Word

Commodities are an important part of today’s global economy. Every facet of our daily lives is greatly influenced by commodities and commodity prices. For the average investor, taking a small part of their portfolio and dedicating it to commodities makes sense. However, do not look to hit “home runs” and make quick strikes on sudden price movements. Leave that to the hedge funds, investment banks, and risk takers.

As a typical investor, you may do well in one of the funds mentioned above, and it can be a way to get your feet wet in the world of commodities. Diversification over several sectors is key: Energy, metals, softs, grains, and infrastructure products like copper and lumber all have a place in the balanced portfolio. Start small, do your homework, and talk to an investment professional to help ensure that the products you are using actually give you the exposure to commodities you desire. Remember, diversification across many sectors will help to reduce volatility and keep you in the game for the long term.

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Evan Pierce has spent nearly 20 years as a commodity trader and market analyst. He is registered with the National Futures Association as a Commodity Trading Advisor (CTA) and has written and edited his own newsletter, The Position Sheet. He grew up in New Providence, New Jersey and now lives in Norwich, Vermont with his wife, three children, and their two Golden Retrievers.

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